What next after Spain's historic no-confidence vote?

Mariano Rajoy's swift and unprecedented removal from power has thrust Spanish political risk to the forefront. While the current political instability stems from Spain's fragmented political landscape and contested territorial model, it is not a new development and does not alter country's medium-term economic outlook. However, the threat of political stalemate represents a major risk for Spain further out.

Last week almost ended brilliantly for Mariano Rajoy (Popular Party, PP), the now former President of the Government of Spain. The five representatives of the centre-right Basque Nationalist Party (PNV) had finally agreed to support the 2018 finance bill (Presupuestos Generales del Estado, PGE) in a vote in Congress (the 350-seat lower house of the Cortès, or Spanish Parliament), in return for promises to phase in a substantial pension increase* and boost public investment in the Basque Country by more than a third. In a repeat of 2017, the PGE was adopted almost eight months late, with support from the 138 representatives of the PP and its regional allies (39% of seats), the 32 representatives of the new centre-right Ciudadanos party (9%) and the five PNV votes (1%). The 176th and final vote once again came from the representative of a regional party from the Canary Islands who was initially elected with the support of the Socialist Party (PSOE).

Securing the PNV's backing meant a double victory for Mr Rajoy, because the Basque independence party had previously refused to renew its support as long as the central government retained control over Catalonia, as it had since the end of October 2017 under Article 155 of the Constitution. Although fresh regional elections were held in December 2017, direct control was maintained because, to lift Article 155, a Catalan government had to be formed, and Joaquim Torra, the new Catalan President sworn in in mid-May, refused to do this without the previous secessionist ministers stripped of office under Article 155, most of whom are being held in preventive custody. The PNV's decision removed the incentive for Catalonia's pro-independence movement to hold off on forming a government in accordance with the Spanish Constitution. This opened the way to lift Article 155 on Saturday, 2 June 2018, the day after Socialist Pedro Sanchez was sworn in as the new leader of the Spanish government.

In the end, then, Mr Rajoy, won a double Pyrrhic victory, as he proved unable to stem the tide of public indignation unleashed by the latest round of corruption convictions for former senior members of the PP who had held office during Mr Rajoy's tenure as party leader. In less than a week, Mr Sanchez confounded expectations by managing to secure backing for his no-confidence vote from the 84 socialist representatives (24% of the seats), the 71 representatives of Podemos and its allies (20%), and the 25 representatives of regional parties (7%), including Catalan separatists and the PNV. Looking at Spain's two greatest challenges, namely fiscal adjustment and the country's territorial model, what can we learn from the first ever successful no-confidence vote in modern Spanish history?

While the Senate, or upper house of the Cortès, where the PP has an absolute majority, could go back on the Basque investment plan (although not the pension adjustment) as a retaliation measure, final adoption of the 2018 budget is not under threat. Senate amendments have to be approved by Congress, and if they are not, the bill that was adopted at the first reading will come into effect. If the PP sends the PGE back to Congress, as is likely, this will be primarily intended to test the heterogeneous alliance of left-wingers and regional parties put together by the PSOE, which promised the PNV that it would stick to the original 2018 budget in return for the Basques' support, whereas both the PSOE and Podemos rejected the 2018 PGE at the first reading. This will be the first test for the most minority government in Spanish democratic history, prefiguring the process of drafting the 2019 PGE, which must be submitted in October 2018. Because the PSOE has promised to abide by European commitments, the fiscal prospects have not fundamentally changed. While the scale of the initial adjustment proposed by the PP, i.e. to cut the deficit from 3.1% of GDP in 2017 to 2.2% in 2018 and 1.3% in 2019, continues to look unworkable, the trend decline (to around 2.5% in 2018 and 2% in 2019) and a return to primary balance in 2019 are still credible. Accordingly, the unstable new government is unlikely to tackle the repeated lack of structural adjustments, but will continue to benefit from solid growth of 2.8% in 2018 and 2.3% in 2019, after more than 3% since 2015. In the absence of structural measures, as exemplified by the postponement of pension reforms, the risk remains the same: any growth shock, although an unlikely scenario right now, could knock this fiscal trajectory off-track.

If Mr Sanchez manages to overcome these fiscal stumbling blocks, he could use his motley alliance to start looking for a solution to the problems posed by Spain's territorial model, of which Catalonia is the most extreme example. The no-confidence vote coincided with the lifting of Article 155, while also signalling waning influence within the independence movement of ousted President Carles Puigdemont, who initially said that his party's representatives should abstain. As a result, Mr Sanchez's election should enable a relative normalisation of relations between Madrid and Barcelona in the medium term, and the coalition of regional voices might be able to make headway in the debate on reforming financing for autonomous communities. The regional parties pledged their support to the PSOE primarily out of fear that Ciudadanos might take power in the event of a snap election in 2018.

Ciudadanos advocates a centralist model that would curtail regional autonomy and scrap the exceptional fiscal status enjoyed by the Basque Country and Navarre. The party is ahead in the polls, and with 28% support since the start of the year, it is draining voters away from the PP, which would look to get no more than one-fifth of votes, just ahead of the PSOE and Podemos. This explains why the regional parties were keen to delay new elections and probably freeze the political landscape in the run-up to regional elections in May 2019, when Ciudadanos may well struggle because of its weak regional presence. So while Mr Sanchez has announced plans to call an early general election before the end of the current parliamentary term in mid-2020, these elections will most likely take place in spring 2019.

Judging by the persistent political fragmentation revealed by the polls and election results in recent years, one thing is clear: if it hopes to have a prolonged stay in power, the executive formed from the next elections will have to be Spain's first ever coalition government to transcend the many fault lines running through Congress, pitting left vs. right, unionists vs, regionalists and traditional vs. new parties. Failure could leave the country mired in a permanent political stalemate, leaving it even more exposed to the next economic shock. With no party calling to quit the eurozone, this represents the main political risk for Spain.

*The Rajoy government agreed to link pension increases to inflation in 2018 and 2019 rather than the revaluation index adopted during the 2013 reforms, and to introduce the pension sustainability factor linking pensions to life expectancy in 2023 instead of 2019 as originally planned.